What Gold's Saying About Where the Dow's Headed

Lately, the stock market and the price of gold have been moving in opposite direction. As the Federal Reserve contemplates the phasing-out of its unprecedented monetary policy moves, stocks have held up quite well despite being near all-time highs, while gold and silver investors have fled the precious-metals markets as the long-awaited implosion of fiat-currency-based economic activity appears less likely to materialize. Precious-metals ETFs SPDR Gold (NYSEMKT: GLD) and iShares Silver (NYSEMKT: SLV) have not only seen extensive price declines but also drops in the number of shares they have outstanding, as the ETFs have sold off some of their bullion holdings even as prices fell.

Historically, many investors have looked at the ratio of the Dow Jones Industrials (DJINDICES: ^DJI) to the price of gold as a gauge of market sentiment. Let's take a look at the relationship between stocks and gold to see what current conditions are telling us.

Real stock market performanceOver the long run, gold has done a relatively good job of appreciating in price in line with overall consumer prices. Compare the number of ounces of gold it would take to buy a car or a suit in decades past with how much gold it would take to do so today, and you'll get relatively consistent results over time.

But stocks and gold have seen much bigger swings in relative value. Take a look at this chart, which shows the ratio of the Dow to gold prices from 1968 to 2008.

As you can see, in the early 1980s, high inflation spurred extremely high gold prices and sent stocks tumbling, bringing Dow/gold ratios below 1.3. Conversely, in the big bull market for stocks in the late 1990s, no one wanted gold, and so the Dow rose to about 40 times the level of gold prices.

After 2008, gold kept rising sharply even as the Dow hit bottom and began to recover, driving the ratio down to around 7. But in the recent collapse of gold prices, the ratio has soared to about 12.5.

What's next?Unfortunately, it's hard to draw strong conclusions from the recent Dow/gold ratio movement. The ratio has historically spent a considerable amount of time below 10, suggesting that gold prices are attractive compared to the Dow and encouraging value investors to consider adding to gold positions. That's consistent with the behavior we've seen in Market Vectors Gold Miners (NYSEMKT: GDX) and gold-mining stocks generally, which have drawn investor interest even in gold's swoon.

Yet gold bears can point to previous peak levels as supporting much lower gold prices. A Dow/gold ratio of 40 would translate to gold prices of about $500 per ounce -- an almost-60% decline from current levels.

The Dow/gold ratio might not help you predict the future, but just knowing it exists and that people look at it can help you better understand some of the movements in both markets. That way, whichever way gold moves from here, you can assess whether the inverse relationship between gold and stocks is likely to continue or appears to be poised to reverse itself.

Find out more about gold and the value-investing proposition it offers by looking at The Motley Fool's new free report, "The Best Way to Play Gold Right Now." Inside, we dissect the recent volatility and provide a guide for smarter gold investing. Click here to read the full report today!

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